Cap Rate Calculator

What a cap rate is

A capitalization rate, or cap rate, is a property's net operating income divided by the price you pay for it. It answers one question: if you bought the building for cash, with no mortgage, what yield would the income stream throw off in the first year? A $320,000 property throwing $20,115 of net operating income returns 6.29 percent.

Two things follow from that definition. It is an unlevered number, so the loan you use changes your cash flow but not the cap rate. And it is a first year snapshot, so it ignores rent growth, price appreciation and the year you sell. Investors use it as shorthand for comparing properties of the same type in the same market, not as a forecast of total return.

Cap rates also invert the usual logic of a price. A high cap rate means you are paying less for each dollar of income, which usually signals more risk: a rough neighborhood, an old roof, a single tenant on a short lease. A low cap rate means the market expects the income to grow or to be unusually safe. Neither number is better on its own.

Building net operating income

Almost every cap rate error comes from a sloppy NOI. The order of operations is fixed: start with the rent the property would collect if fully occupied, subtract a vacancy and credit loss allowance, then subtract the costs of running the building.

Operating expenses include property tax, insurance, repairs and maintenance, utilities the owner pays, landscaping and snow removal, management fees, and leasing costs. They exclude four things: the mortgage payment, capital improvements, depreciation, and income tax. The IRS treats mortgage interest as its own deduction and residential rental buildings as 27.5 year straight line property under Publication 527, which is a reminder that both the loan and the depreciation schedule sit outside the operating statement.

The capital expense line is the one people argue about. A new roof is not an operating expense in accounting terms, but it is a real cost of owning the building. Most buyers handle that by subtracting a reserve of roughly 5 to 10 percent of gross rent from NOI before computing the cap rate, and saying so when they quote it.

Worked example: a $320,000 duplex

Two units rent for $1,450 each, so gross scheduled rent is $2,900 a month or $34,800 a year. Vacancy and credit loss at 5 percent takes $1,740, leaving effective gross income of $33,060.

The operating expenses total $12,944.80, or 37.2 percent of gross rent. Divide NOI by the price: 20,115.20 / 320,000 = 6.29 percent. Add 2 percent closing costs and the all-in basis is $326,400, which drops the cap rate to 6.16 percent, a fairer number for a buyer who has to pay those costs on day one.

Notice what is missing from the table: the mortgage. That is deliberate. The cap rate describes the property, and the loan belongs to the buyer.

Turning a cap rate into a price

Flip the formula and the cap rate becomes a valuation tool. Price equals net operating income divided by the cap rate, where the cap rate comes from recent sales of similar buildings in the same market.

This is how the two sides of a negotiation argue without either being wrong. The seller points at comparable sales that traded at 5 percent and asks $402,000. The buyer points at a new property tax assessment and a roof that is 20 years old, argues the NOI is overstated, and offers $287,000 at a 7 percent cap. The gap is not arithmetic, it is a disagreement about risk and about which NOI is real.

A 1 point move in the cap rate changes the value of this NOI by 12 to 20 percent, and the smaller the cap rate, the bigger the swing. That sensitivity is why small differences in the expense assumptions matter so much more than they look.

Cap rate is not your cash flow

A 6.29 percent cap rate does not mean a 6.29 percent return on your money. Add a mortgage and the arithmetic changes completely.

Say you buy the duplex for $320,000 with 25 percent down and pay 2 percent closing costs. Your cash in is $80,000 plus $6,400, so $86,400. The loan is $240,000 at 7.25 percent over 30 years, which works out to $1,637.22 a month or $19,646.64 a year in debt service.

Subtract that from NOI and the cash flow is $468.56 a year. Cash-on-cash return is 468.56 / 86,400 = 0.54 percent. The property yields 6.29 percent unlevered and half a percent on your actual cash, because the loan costs almost exactly what the building earns.

That gap is the honest picture for a highly financed deal in a high rate environment. A loan magnifies whatever spread exists between the cap rate and the loan constant. When the loan constant is below the cap rate, borrowing adds to your return. When it is above, as here, borrowing eats it.

Cap rate, GRM and the 1 percent rule

Three shortcuts show up in listing sheets, and they measure different things.

The gross rent multiplier of 9.2 means you pay $9.20 for every $1 of annual rent. It is fast and it is crude: two buildings with the same GRM can have wildly different tax bills, and the cheaper one on a GRM basis can be the worse deal.

The 1 percent rule says monthly rent should be about 1 percent of the purchase price, and this duplex fails at 0.91 percent. It is a screening filter, not a valuation, and it behaves badly in expensive coastal markets where nothing passes it and in cheap markets where everything does.

What moves cap rates

Cap rates are set by the market, not by the building alone, and they move for reasons that have nothing to do with your property.

Interest rates. Most buyers finance part of the price, so the cost of debt sets a floor under the cap rate. When mortgage rates rise, buyers who need a loan can pay less for the same income, and cap rates drift up. When rates fall, the reverse happens and prices climb.

Risk and growth expectations. A building in a neighborhood with rising rents and new employers trades at a lower cap rate than an identical building with flat rents, because buyers pay for expected growth. Older buildings, single tenant buildings, and properties with deferred maintenance carry higher cap rates for the same reason.

Supply of capital. When lots of buyers chase few properties, cap rates compress. When credit tightens, they widen quickly, and the properties that traded at 5 percent in a boom are the ones that reprice hardest.

Asset class and location. A 12 unit apartment building, a single family rental, and a strip mall in the same city do not trade at the same cap rate. Compare like with like, and use local sales rather than a national average.

Mistakes that inflate a cap rate

A cap rate computed from optimistic numbers is worse than no cap rate at all, because it looks precise. These are the usual ways the number gets too high.

Using gross rent instead of NOI. The most common error. Gross rent ignores vacancy, taxes, insurance and repairs, and can double the reported yield.

Forgetting vacancy. A building that has never been empty still needs an allowance. The Census Bureau's Housing Vacancy Survey publishes a national rental vacancy rate every quarter, and local numbers run higher in weak markets.

Leaving out owner paid utilities. Water, sewer, trash and heat are real costs in many small buildings, and they are the first line sellers drop from a pro forma.

No management line. Self managing a duplex saves 8 percent, but that is a job, and a buyer who will hire a manager should price it in.

Using the pro forma instead of the tax return. Ask for the last two years of Schedule E, which shows what was collected and spent.

No capex reserve. Roofs, furnaces and water heaters wear out on a schedule. A property with a 20 year old roof and no reserve is not a 6.29 percent deal, it is a 6.29 percent deal with a bill coming.

Ignoring closing costs and repairs at purchase. The cap rate on your all-in basis is the one you will earn, and it is usually 0.1 to 0.4 points lower than the one on the list price.

One last caution: a cap rate is a one year measure. A building with a below market lease and a building with a lease that resets next month can post the same number and be worth much different amounts.